While much has been made of the expiration of the Federal Reserve’s $300 Billion quantitative easing program, there are still many more ways in which the Fed can pump the markets with liquidity that need never be paid back to the recipients.  In this article, we take a look at the ramifications of some recent developments with regard to the Treasury and Federal Reserve that will again provide fodder to the equities markets, as well as revisiting our previous work on how money supply has impacted the economy and what it tells us of the potential correction down the road.

As we wrote two days ago, Treasury is effectively winding down its Supplemental Financing Program, the stated intention of which on its inception in September 2008 was to, “drain reserves from the banking system, and therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”  Delving into the mechanics of it, here is what happened:

Treasury announced special auctions for cash management bills, the proceeds of which were placed on deposit with the Federal Reserve in a special account (as opposed to the proceeds being kept by Treasury to fund the government).  This allowed the Federal Reserve to use these funds (which topped out at $558.9 Billion in November 2008) to borrow or buy securities primarily from banks and broker dealers to help “unfreeze the credit markets.”  The Fed could have simply borrowed or bought securities with money it printed, but this would have expanded its balance sheet by creating excess reserves in the accounts that banks are required to keep with the Fed.  These reserves can be multiplied by at least ten times and used by banks for lending.  At the time, the Fed was rightfully concerned about inflation becoming unmanageable once the credit markets thawed, and about being able to keep the Fed overnight lending rate (fed funds target rate) above zero.  Accordingly, Treasury’s SFP helped to keep the Fed balance sheet under control (if you can call a multiple hundred percentage increase “under control”).  The amount of money that flowed into the financial markets from the SFP was the same as it would have been had the Fed printed the money; however, SFP money could not be multiplied by banks.

Congress granted the authority to the Fed to pay interest on excess reserves held by banks on deposit with it as of October 1, 2008.  This new tool obviated the need for the SFP as the Fed could now simply incentivize banks to not lend against their excess reserves (by paying them interest to keep their reserves at the Fed).  Accordingly, in November 2008, Treasury announced it would reduce the SFP, and it has held steadily at $200 Billion for most of 2009.

On Wednesday, Treasury announced that it would allow the SFP to “decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over.”  As we wrote above, Treasury issued special cash management bills as opposed to its standard arsenal of regularly auctioned bills (such as the 4 Week, 3 Month and 6 Month Bills).  We have identified these bills (all were 70 day duration) by their CUSIP, auction amount, primary dealer take (to be explained later) and maturity date (each of which is a Thursday):

Upon maturity, the SFP account at the Fed will be deducted by the total auction amount with the funds returned to the purchasers of the bills.  The consequences of this are:

1. Should the Federal Reserve require additional funds to finance its buying and borrowing of securities (Agency POMO, MBS purchase, TALF, etc.), it will need to print money in the amount that the SFP has been decreased.  This is not too much of a long term issue since, as we wrote above, it is able to pay interest on excess bank reserves to keep inflation in check.
2. Treasury can now issue longer term Notes and Bonds to replace the shorter term 70 day cash management bills.  This is more important to Treasury’s long term objectives, especially as it quickly approaches the $12.1 Trillion debt ceiling this fall.
3. Without the rollover of the $185 Billion in cash management bills, assuming constant demand for shorter duration bills, the regularly scheduled Treasury Bill auctions (4 Week, 3 Month, 6 Month, etc.) should experience increased demand, which will put downwards pressure on short term rates and keep the US Dollar carry trade alive and well (a topic for another article).
4. Because primary dealers will not be expected to buy any more of these SFP cash management bills, they may use these funds for other purposes.

As to 4, above, what might these purposes be?  As we have seen with the permanent open market operations (POMO), it appears that much of the stock market ramp (at least for the first half of the 2009 rally) was demonstrably accomplished with POMO funds paid to primary dealers that plowed the money into stocks.  We have also correlated large increases in bank non-borrowed excess reserves (green in chart below) with stock market ramps.  The chart from the previous post is updated here:

Indeed, because the major primary dealers are US banks, most of the $114.1 Billion returned to them upon maturity of the SFP bills will end up in this category of non-borrowed excess reserves.  Some of it may be required to support future Treasury auctions, especially if Treasury ups the longer dated auctions that have less foreign support (primary dealers are required to soak up excess supply at auctions).  Indeed, next week, the 2 Year, 5 Year and 7 Year offering amounts have each been increased by $1 Billion.  However, the potential is for at least a sizable portion of the $30 to $35  Billion to hit the equities markets each of the next six Thursdays after having been leveraged by 10 to 100 times or more.

Also, though quantitative easing in the form of Treasury POMOs is ending soon as it approaches the $300 Billion ceiling, the Fed is compensating with increased Agency POMOs (another $4 Billion bought today, $285 Billion to date), not to mention a total of $651 Billion in mortgage backed securities bought by the Fed this year.

The above is our warning to the shorts.  Now, our warning to the longs.  Below is our updated chart of M2 Money Supply Volatility, that we first brought to our readers’ attention in late July 2009.

The unprecedented contraction in money supply, as measured by 13 week percent change M2 non-seasonally adjusted money supply(yellow in chart), only intensified into early September 2008, as evidenced by the double dip at the far right edge.  What this tells us is that the equities rally is running on vapors (likely in large part from the bank non-borrowed excess reserves portion of M0), with nothing to back it up (in the form of money circulating in the broader economy) once the vapors disappear.

Interestingly, Wednesday’s rally to 1074 in the cash S&P 500 touched a crucial level in the heavily traded SPY (S&P 500 exchange traded fund), which is the volume  weighted average price (VWAP) of the entire down move from the October 11, 2007 high.  The bulls and bears are thus at a crucial equilibrium point, and the coming weeks will announce the medium term winner.

In short, traders should be mindful of the potential for massive buying sprees as the $114.1 Billion is returned to primary dealers over the next six weeks (along with continued Agency POMO and MBS purchases) and also of the potential for the floor to fall out from under this rally once the funny money dries up.  The next downturn will not be instantaneous, and there will be warning signs, which we will report on as always.

We are neither perma bears nor perma bulls, but are fortunate to have the luxury of reevaluating the markets on a day to day basis and to be able to adjust accordingly.  True to history, it will be the longer term investors that will ultimately bear the brunt of this monetary and fiscal malfeasance.

Disclosure: No positions as of time of publication.

The Precise Take – Equities maintaining highs on options expiration Friday

Leaders Analysis: 30 Year T-Bond futures were able to post sizable gains yesterday on equities intransigence.  The EuroYen was up again, able to pierce resistance from earlier in the month, but not able to break through it (similar to crude), with gold posting nominal new highs.  The 30 Year has consolidated since June, and it is the 30 Year that we believe will be the ultimate confirmation of a top in equities (should it ever come), with a break of the 121 to 122 resistance area as such confirmation.

Treasury Update:  We will be posting an update by noon today that explores further the $185 wind down of the Treasury Supplementary Financing Program, next week’s Treasury Auctions and recent developments in the monetary base and money supply.  Subscribe for free updates here.

Medium Term Analysis:  We had given equities until yesterday to confirm an interim top, and such confirmation did not come.  Accordingly, while a correction is always possible given the house-of-cards nature of this rally, we must look upwards to the next price target of 1126.25 over the coming weeks.

Trading Today: Today is quadruple witching options expiration and, with the exception of the August opex trading day which was able to clear overhead resistance, the others in this 2009 rally have been below average range.  Accordingly, we are not expecting a volatile day and will… 

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The Precise Take – Continued strength overnight into options expiration Friday

Leaders Analysis: As we updated yesterday, the leaders are confirming the strength in gold and equities, with correlations that match the past year’s norms. 

Treasury Update:  As we also updated yesterday, Treasury has announced the effective cessation of its Supplemental Financing Program that was intended to help the Fed with its balance sheet one year ago, with the effect that $185 B could possibly work its way into the markets over the coming weeks.  We received many questions and comments and will post an update before Friday noon at the latest after we have seen the Fed’s latest statistics published after today’s close.  If Treasury gave appropriate notice of this change, any trading effects should not be felt until next Thursday. 

Medium Term Analysis:  Yesterday, we did not see the distribution day we wanted to confirm an intermediate top.  We could still get one today per our less likely scenario, but we would need to form a bearish engulfing candle with a close below yesterday’s overnight low of 1044.50 to have this possibility.  As always, we don’t front run possibilities; however, we do adjust our day trading accordingly.  Tomorrow is options expiration day, and next week features the end of month Treasury auctions and an FOMC Announcement Wednesday.  Any major change to monetary policy is unlikely to be announced, and we must take heed of the historical probability of another surge in equities on this day.  If we don’t correct today, the next upside targets range from 1126.25 to 1160.75 and are reachable by early October.

Trading Today:  Overnight, the ES reversed down off the confluence of daily R1 and monthly R2 at 1070.00.  This will be a key level for the longs to break to make new highs this week.  Above, and we are outright intraday bullish, watching 1074.75 to 1076.75 as a potential reversal area and which we are willing to…

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The US debt ceiling currently rests at $12.104 Trillion, of which $11.792 Trillion is outstanding as of September 14, 2009.  The debt ceiling is the maximum debt allowed by statute (not including future liabilities, such as Social Security and Medicare).  Any change must be enacted by Congress, and as we quickly approach the ceiling this fall, such a debate would be easily politicized.  In anticipation of such friction, Treasury will be cutting corners wherever it can to continue to issue debt at a record pace, preferably on the long end of the yield curve.  One such corner is the Treasury’s Supplementary Financing Program, which was created in September 2008.  The original press release (emphasis ours):

September 17, 2008

Today, the Treasury Department announced the initiation of a temporary Supplementary Financing Program. The program will consist of a series of Treasury bill auctions, separate from Treasury’s current borrowing program, with the proceeds from these auctions to be maintained in an account at the Federal Reserve Bank of New York. Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives. Treasury Announces Supplementary Financing Program

The program’s original purpose was twofold: (1) it was an accounting trick to help keep the Fed balance sheet in check, and (2) it helped the Fed keep the effective fed funds target rate from slipping to 0% (this was prior to the Fed’s ability to pay interest to banks on excess reserves which eventually allowed it to do the same thing).

In November 2008, as the program hit its peak amount at $558.9 Billion, Treasury announced it would wind down the program.  As of September 9, 2009, there was $199.9 Billion under this line item.  Just released this morning, Treasury will allow the Supplementary Financing amount to drop to $15 Billion as maturing bills are not rolled over, thus creating room for an eventual $185 Billion in longer term debt issuance to the public (emphasis ours):

September 16, 2009
TG-289

Treasury Issues Debt Management Guidance
on the Supplementary Financing Program

Washington – The U.S. Department of Treasury today issued the following statement on the Supplementary Financing Program:

“Treasury currently anticipates that the balance in the Treasury’s Supplementary Financing Account will decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over. This action is being taken to preserve flexibility in the conduct of debt management policy.”

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However, it will take Treasury some time to roll the $185 Billion into longer term issues (assuming that’s what it wants to do).  And, if the Fed does not concurrently offset the $185 Billion drop on its balance sheet, it will likely be reflected over the coming weeks as a $185 B increase in bank non-borrowed excess reserves (which are by definition total reserves minus borrowed reserves).  As we have noted before, we have found large increases in bank non-borrowed reserves to be correlated with equities gains in this 2009 rally.  The money will need to find a short term home somewhere and, if it is in the hands of the large financial institutions, it can easily be leveraged 100 times or more and pumped into the stock market.

Bottom line–though we believe in the possibility of a correction from the 1066 area of the S&P 500 by tomorrow, this development could be another shot in the arm to subsequently ramp equities in the face of dwindling permanent open market operations, with the side benefit of allowing Treasury to eventually rollover $185 B of short term debt into longer term as it approaches the debt ceiling.

Updating our previous posts in this theme, below is a chart of gold priced in the Euro, Japanese Yen, Australian Dollar and Canadian Dollar.  Gold in Yen has intraday broken above its Sep 03 09 closing price, though gold in the commodity currencies of the Australian and Canadian Dollars has not.

Update 1:27 pm EDT: Corrected “Gold in Euros” to “Gold in Yen”, above.  Gold in Euros is below its Sep 3 09 high.

10:41 am EDT:  EuroYen has reversed up and 30 Year T-Bonds have reversed down, which both now confirm equities and gold strength.  Though fading the 1053.25 resistance area on the open into the gap was a profitable trade, we no longer look to short at these levels.  We will likely not take a position unless and until the day session range is broken (1047.75 to 1053.25)  and then trade in the direction of the breakout.

The Precise Take – Equities maintaining strength in the midst of heavy news week

Leaders & Medium Term Analysis: Gold shot up to 1023.30 overnight (basis Dec 09) on continued US Dollar weakness, which also has helped fuel the continued surge in equities.  As we have been writing, we have a very good probability of a top either today or tomorrow, but need to see confirmation with a close below 1030 in the ES by tomorrow.  Overnight, the ES has maintained strength by yesterday’s highs, but 30 Year T-Bond futures are up slightly and the EuroYen forex cross down materially, which are both non-confirmations for equities and gold strength.  The ideal top will by a spike up in equities on one of the pre-market reports this morning with a distribution day that closes below 1030.  Alternatively, tomorrow’s two 8:30 am reports could be the bearish catalyst.  If this scenario does not play out, there is very little overhead resistance above 1066.00 until we get to the 50% retracement of the entire down move at 1126.25, with other Fibonacci resistance at 1144.75 and 1160.75.

Treasury Analysis:  Tomorrow, Treasury will announce next week’s auction schedule.  Last month, the continued upward trend in auction amounts was halted, and we expect this month to be on par with to slightly less than last month.  We do not expect the same nervousness in the bond markets that we had in previous months as recent long term auctions have gone well and yields are testing support rather than on the verge of breaking through upside resistance.  If we do get the reversal in equities this week, the 30 Year should be finally able to break through its resistance (and yields through support) and we would likely see a short covering rally up to at least the 124-125 level.

Trading Today:  As we write, the markets have reacted tepidly to CPI and the Current Account reports at 8:30 am, and there are still TIC and Industrial Production before the market opens.  We are willing to cautiously buy strength between 1042.50 to 1046.00, but become intraday bearish below, mindful of the strong possibility of a longer term correction.  Therefore, we will not…

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11:24 am EDT:  We incorrectly identified Wed and Thurs of this week as the two days on which the Federal Reserve Bank of NY would conduct permanent open market operations (POMO).  In fact, it is today (Tues) and tomorrow (Wed).  This increases the likelihood of a correction to be underway by tomorrow (Wed), instead of Thursday.  Regret the error.  Today’s POMO results were for a meager $2 B, so quantitative easing could conceivably continue beyond this week with smaller auction amounts.

After an initial failed test of the 8:30 am spike high to 1048.75, longs have supported the ES in the expected area of 1037.25 to 1039.50 per our morning report.  If the ES accepts value in the upper half of the combined session range (1043.50 and higher), there could be a successful afternoon push to new highs, as we have seen in previous days.  Otherwise, the conditions for this morning’s high being the September high are partially in place.  We would like to have seen a directional push down by now, but a close under 1030 still signifies the top is in for us.  For this reason, we will not be buyers on any further weakness (including test of 1038.25 low), and will instead begin intraday shorting on a break of 1037.00, should it occur.

The Precise Take – Strength in equities into three day critical news period

Leaders & Medium Term Analysis: The correlation divergences in our leaders has more or less disappeared, with equities and the EuroYen forex cross up yesterday, Treasuries and the US Dollar down, and gold treading water.  Over the next three day, a slew of major reports to be released pre-market, including PPI, Retail Sales, CPI, and Housing Starts, are likely to give equities pause, as they have done in months past.  Combined with the statistical likelihood of a material correction going into the third week of October as a result of record money supply contraction, we expect the monthly high to be posted on or before Thursday.  The first sign will be a more bearish than expected reaction to one of the major reports.  Ideally, there would be a new spike high on a bullish report and a reversal down in price into the open with a close below the 1030 to 1033 support area in the ES.  We have taken into consideration this week’s POMO schedule (to be conducted Wed and Thurs), which will likely burn the remaining unused portion of the quantitative easing’s $300 B mandate.  Thursday for sure needs to close below 1030 to validate this theory, otherwise the extension upwards in equities will likely continue.  Our upside price target range remains 1053.25 to 1066.00, which are major resistance areas on the daily continuous futures chart for the ES.  However, if we get the reversal criteria before the area is reached, we will not hold out for the extension.

Trading Today:  Longs should heavily defend today the 1037.25 to 1039.50 area, which includes the daily pivots and yesterday’s (and long term) market profile points of control.  We become intraday bearish below, watching price action around the 1029.75 to 1031.00 support area, where we may fade long.  Below, and we will not pick bottoms as the end of this rally could be in.  As we write, equities are heading higher off Retail Sales at 8:30 am and have entered our intraday bullish area (above 1045.25).  There are several potential reversal zones up to the 1057.75 area, so while we do not want to pick tops today (as we feel the eventual medium term reversal is likely to come tomorrow or Thursday), we will…

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The Precise Take – Modest overnight weakness into slow news day

Leaders Analysis:  As we wrote last week, equities and Treasuries should not continue to both advance in lockstep and we expect a return to the negative correlation early this week.  After the 30 Year T-Bond future rebounded to the upside from very strong support last Wednesday, it reached and backed off very strong resistance in the 121-122 area last Friday.  The most likely scenario is that equities reach new highs this week as Treasuries retreat further, at least into Wednesday, with Wednesday’s CPI or Thursday’s Housing Starts potential marking another reversal (down equities, up Treasuries).  With quantitative easing (POMO) drawing to an end, also in the cards is another wildcard in the form of an announcement by the Fed.  Three top Fed officials speak today and could give clues to the Fed’s next direction.  Of particular interest is San Francisco Fed Res Bank President Janet Yellen (3:50 pm EDT), who often speaks Bernanke’s mind.

Trading Today:  There is a slow economic calendar for today, so we will try to trade the range between the overnight low of 1025.00 and strong confluence resistance at 1037.25 to 1038.25, which includes the daily gap/pivot area and the Dec 09 contract’s highest volume point of control.  Should price trade outside this range, we would consider fading short the 1042.75 to 1043.75 resistance area or fading long the 1015.25 to 1017.75 support  area.  Beyond, and we will not attempt to…

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